China Franchise Law

  1. What forms of business entities exist that would be relevant to the typical
    franchisor?

    Foreign enterprises have two options when establishing a franchise
    in China.

    FIEs

    The first option is to establish a: 

    Foreign-invested enterprise (FIE) 
    that would then act as a sub-franchisor. 

    There are three typical FIE structures that could act as a subsidiary 
    to the foreign enterprise:

    Wholly foreign-owned enterprises (WFOEs), 

    Equity joint ventures (EJVs) or

    Cooperative joint ventures (CJVs).

    A wholly foreign-owned enterprise is independently owned by a
    foreign enterprise without the aid of a Chinese partner. Though this
    business structure is preferable because the investor can keep 100
    per cent of the profits, the law strictly regulates the establishment
    and operation of a WFOE and, in some industries, is entirely prohibited.
    Although current franchise regulations are silent as to whether
    a WFOE may create a franchise within China, it is likely that the law
    would permit a WFOE to take the position of a sub-franchisor. This
    sub-franchisor would then be in the position of granting licenses to
    any local corporate franchisee by entering into a sub-franchise agreement.

    However, due to the strict, often misunderstood, guidelines
    on the formation of businesses, it is not advisable to have a WFOE
    establish a franchise in China.

    Joint ventures are the most functional way of creating the necessary
    local know-how when establishing a business entity in China,
    especially for franchises. An EJV is a limited liability partnership
    between a foreign company and a Chinese legal person. Profit distribution
    and shareholding is directly proportional to each partner’s
    investment. CJVs are becoming more accepted in China but are still
    prohibited in many industries. This business structure allows the foreign
    entity and Chinese legal person to have more flexibility in structuring
    the shareholding and profit-sharing. Similar to the WFOE,
    both of these joint ventures would be considered as a subsidiary to
    the parent franchise abroad. As such, each would have the same legal
    rights and liability as the franchisor.

    Direct contractual relationships

    The second option for a foreign investor is to avoid creating a business
    entity in China and create a direct contractual relationship with
    a local franchisee. In doing so, the foreign business can establish a
    local network while maintaining its domicile abroad. Exercising this
    option allows the foreign investor to avoid the legal barriers that are
    faced when establishing a FIE.

    For domestic franchisors, the regulations are seen as another type
    of contract. These franchisors engage in a direct contractual relationship
    with their franchisee.

    2. What laws and agencies govern the formation of business entities?

    The Company Law of the People’s Republic of China (PRC) provides
    the general legal framework for all limited liability companies,
    domestic and foreign. All foreign entities must also comply with the

    Catalogue for the Guidance of Foreign Enterprises (FIE catalogue),
    which is updated regularly and categorizes foreign businesses and
    industries into ‘encouraged’, restricted’ and ‘prohibited’. Generally,
    any business or industry not listed in the catalogue is permitted.

    Other relevant laws that govern the formation of business entities
    include, inter alia the Labor Contract Law (2007), the Enterprise
    Income Tax Law (2007), the Contract Law (1999), the Labor Law
    (1994) and the Land Management (1998). The Partnership Enterprise
    Law (2007) applies to Chinese legal persons wanting to establish
    a business partnership in China with no foreign entities.

    On a national level, the State Council is the chief administrative
    authority for the formation of business entities. Acting in the
    interest of the State Council is the Ministry of Commerce, the State
    Administration for Industry and Commerce (SAIC), and the National
    Development and Reform Commission. Investors go directly to these
    administrations only if the business meets certain national thresholds
    or if the business is interprovincial. In most circumstances, the local level
    administration evaluates and approves the business proposal.
    These administrations vary according to autonomous region, province
    or municipality.

    3. Provide an overview of the requirements for forming and maintaining a
    business entity.

    During the initial stage, the foreign entity and their Chinese partner,
    if applicable, must supply to either the local agency or the Ministry
    of Commerce (MOFCOM):

    • a general application letter introducing the investor and planned
    business project in China;

    • articles of association (including all of the details of management
    and capitalization of the company);

    • a feasibility study report including planned business activities and
    financial background information;

    • a letter of creditworthiness;

    • a valuation report of state-owned assets (if applicable);

    • a list of merchandise to be imported or exported;

    • a list of FIE directors;

    • a copy of land-use rights document or lease, or both;

    • a power of attorney for representative handling the application;
    and

    • a copy of any trademark licenses, patents, tech transfer, service
    contracts, etc.

    After obtaining a certificate of approval from the local agency or
    MOFCOM, the investor files an application with the SAIC in order

    28 How to obtain a business license.

    If a business falls within the ‘restricted’
    category as per the FIE catalogue, then preliminary approval must
    be granted by the National Development and Reform Commission
    (NDRC) before submitting the application to the Ministry of
    Commerce. Additional administrative approval might be required
    depending on the location and type of business.
    In order to maintain a it position as a business entity, the business
    must annually update any new information to the necessary officials,
    pay taxes quarterly, and ensure that all practices comply with the
    laws of the PRC.


    4. What restrictions apply to foreign business entities and foreign
    investment?

    The FIE catalogue contains a comprehensive list of all the restricted
    and prohibited industries that may not be established by a foreign
    business entity. In addition to the restrictions outlined in the FIE catalogue
    is the generic provision that a business may not go against the
    health, morals or development of the People’s Republic of China.

    5. Briefly describe the aspects of the tax system relevant to franchisors.

    How are foreign businesses and individuals taxed?
    All business entities are subject to the new Enterprise Income Tax
    Law of the PRC (2007). This law created a unified 25 per cent tax
    rate for both domestic and foreign entities. Prior to the new tax law,
    preferential treatment was given to all foreign entities by the granting
    of tax exemptions and reductions. Currently, the Notification
    of the State Council on Carrying out the Transitional Preferential
    Policies Concerning Enterprise Income Tax contains a comprehensive
    outline of specific industries and locations that qualify for a tax
    exemption or reduction. Typically, a franchise will not qualify for a
    tax reduction or exemption; however, the franchise may deduct payments
    already paid abroad to offset taxes in China, but this amount
    may not exceed the tax payable.

    Since a franchise engages in the sale and importation of goods
    in China, the franchisor or sub-franchisor must pay a value added
    tax (VAT) of 17 per cent at the time of importation. In addition, a
    franchise must pay a business tax that ranges from three to five per
    cent depending on the revenues generated. If a business withholds
    profits, the business tax can be between 10 and 20 per cent, depending
    on the business’s domicile.

    Businesses are required to audit every month and taxes, except
    for VAT, are paid quarterly. Reconciliation is done at the end of the
    year, usually at the end of December.

    6. Are there any relevant labor and employment considerations for
    typical franchisors? What is the risk that a franchisee or employees of a
    franchisee could be deemed employees of the franchisor? What can be
    done to reduce this risk?

    There is a general provision that states that a franchisor’s obligations
    to a franchisee are to provide, business guidance, technical support
    and business training. However, there are no specific provisions that
    address labor or employment considerations. As such, any labor
    or employment consideration is addressed by the Labor Law of
    the PRC.

    This law states that an employee (aged 16 and over) may not
    work more than eight hours a day and 44 hours a week. Should the
    employee exceed one hour of overtime per day or three hours due
    to a special reason, he or she is entitled to 150 per cent pay. If the
    employee is not granted a guaranteed day of rest within a week, the
    employee is entitled to 200 per cent of his or her pay. Finally, if an
    employee works on a national holiday, he or she may be paid 300 per
    cent pay. Wages are generally determined by economic factors such
    as the daily cost of living in the area.

    In addition, the employer must promote good health, safety and
    the welfare of its employees. This includes contributing to a number
    of social insurance and welfare funds that assist employees with
    healthcare, housing and pensions.

    Since a contractual relationship does not exist between the franchisor
    and the employees of the sub-franchisor, there is only a low
    risk that these employees will be deemed employees of the franchisor.
    In order to prevent such confusion, the franchisor may require that
    the sub-franchisor add a provision in each employment contract that
    severs the franchisor from employment liability.

    7. How are trademarks and know-how protected?

    The regulations stipulate that the protection of trademarks and
    know-how shall be handled in accordance with all applicable law
    and administrative regulations.

    According to the trademark law, the first person to register the
    mark receives trademark protection. Unregistered marks may also
    be protected if the mark has been declared as a ‘well-known mark’
    by a court or administrative authority. The application process takes
    12 to 18 months and protects service marks, collective marks and
    certification marks.

    The Anti-Unfair Competition Law ensures that the business
    know-how of the franchisor is sufficiently protected. This law provides
    protection for any information that is not known to the public,
    provides economic benefits to the owner, is of practical application,
    and has been subject to steps by the owner to maintain its secrecy.
    Any misuse of the franchisor’s business know-how is subject to criminal
    prosecution.

    8. What are the relevant aspects of the real estate market and real estate
    law?

    Because most land is state-owned, enterprises and individuals may
    only possess the right to use land, not the right to own it. Franchises
    may obtain this right for up to 40 years. Upon expiration of the
    grant term, the land and the title to all the structures and attachments
    reverts to the state without compensation. Investors wanting to avoid
    reversion must, before the term of use expires and under new contractual
    terms, apply for an extension to the local branch office or
    Ministry of Land and Natural Resources (MLNR).

    Land-users cannot resell property; instead, the land-use right may
    be transferred through assignment or lease. An assignment occurs
    when the land-user transfers all rights to use the land to an assignee
    through a written contract. A lease occurs when the land user transfers
    his right to use the land for a period of time to a lessee. The lessee
    pays rent to the lessor throughout its possession of the right to use,
    but the lessor remains responsible for continued performance of the
    original land grant contract.

    In addition, current law restricts foreign development of land,
    especially the development of land for leisure activities. In fact, due
    to exploitation concerns, the government forbids foreigners from
    acquiring land from the state. As such, if a foreign entity wants to
    develop land, it must first establish a network with a domestic partner
    who has the legal right to acquire land from the state and then
    develop the land accordingly. Some stipulate that this rigid requirement
    will be altered as China continues to attract a significant
    amount of foreign investors.

    Laws and agencies that regulate the offer and sale of franchises

    9. What is the legal definition of a franchise?

    A franchise refers to a business operation by which a franchisor, an
    entity that possesses a registered trademark, enterprise mark, patent,
    know-how, or any other business resource, confers by way of
    contract the resources to another business operator (franchisee). The
    franchisee pays franchising fees to the franchisor and conducts business
    operations under the uniform business model as stated by the
    contract. No entity or individual other than an enterprise may conduct
    the franchise business as a franchisor (that is, no natural person
    may engage in franchising).

    10. Which laws and government agencies regulate the offer and sale of
    franchises?

    The relevant agencies that regulate the offer and sale of franchises, in
    descending authority, include the State Council, MOFCOM and the
    Ministry of Commerce of specific provinces, autonomous regions or
    municipalities under the Central Government. Other agencies might
    apply depending on the industry.

    The controlling law for franchising in China is the Regulations on
    Administering Commercial Franchise (2007). Ancillary to this law are
    the Administrative Measures for Archiving Commercial Franchises
    and the Administrative Measures for the Information Disclosure of
    Commercial Franchise (2007).

    11. Describe the relevant requirements of these laws and agencies.

    The law requires that both the franchisor and franchisee are legal
    entities. Prior to the acceptance of the contractual terms, the franchisor
    must disclose all relevant information to the franchisee as outlined
    in the Administrative Measures for the Information Disclosure
    of Commercial Franchise. Within 15 days of the conclusion of the
    contract, the franchisor must submit a signed copy of the agreed
    upon terms and all of the relevant parties’ contact information to
    the local Ministry of Commerce as per the Administrative Measures
    for Archiving Commercial Franchises. Upon submitting the required
    documents, the Ministry of Commerce will review the application
    and issue an approval of the franchise within 10 days. Approval from
    the Ministry of Commerce must be granted before the franchisee may
    engage in daily business transactions.

    12. What are the exemptions and exclusions from any franchise laws and
    regulations?

    The current franchise law does not contain any exemptions or
    exclusions. Even though the franchise regulations do not contain
    any exemptions or exclusions, certain business stipulations by the
    government might apply. These stipulations vary depending on the
    industry and location. Other than the industry-based stipulations,
    no franchise may burden the public welfare or be against the government’s
    beliefs.

    13. In the case of a sub-franchising structure, who must make pre-sale
    disclosures to sub-franchisees? If the sub-franchisor must provide
    disclosure, what must be disclosed concerning the franchisor and the
    contractual or other relationship between the franchisor and the sub-
    franchisor?

    In the case of sub-franchising, the sub-franchisor assumes the same
    legal responsibilities as a franchisor. As such, the sub-franchisor must
    disclose all presale information that a franchisor would be required
    to disclose. In addition, the sub-franchisor must disclose the contractual
    relationship between franchisor and the sub-franchisor to the
    sub-franchisee.

    14. What is the compliance procedure for making pre-contractual disclosure
    in your country? How often must the disclosures be updated?

    A franchisor must disclose all of the information outlined in the franchising
    regulations at least 20 days prior to the conclusion of the
    franchise contract.

    All changes in information must be submitted by the franchisor
    to the franchisee in a timely manner. Failure to submit changes in a
    timely manner warrants rescission by the franchisee and criminal
    fines may be instituted by the Ministry of Commerce. The franchisor
    must also submit changes to the Ministry of Commerce in the first
    quarter of every year.

    15. What information must the disclosure document contain?

    At a minimum, a franchisor must provide:

    • the name, domicile, legal representative, registered capital, business
    scope of the franchiser, and basic information in respect of
    the franchised operations;

    • the basic information in respect of the registered trademark,
    enterprise mark, patent, know-how and business model of the
    franchiser;

    • type, amount of franchising fees and payment method;

    • prices and requirements for providing the franchisee with products,
    services and equipments;

    • specific contents of business training and other services to be
    continuously provided to the franchisee, as well as the methods
    and implementation plans;

    • concrete measures for guiding and supervising the business activities
    of the franchisee;

    • the investment budget for the franchise outlet;

    • the business evaluation of franchisees currently existing within
    the territory of China;

    • digests of the financial statements and audit reports for the past
    two years;

    • the condition of all franchise-related lawsuits and arbitration for
    the past five years;

    • any record of major illegal business operations; and

    • any other information as prescribed by the commerce department
    under the State Council.
    Additional requirements are outlined in the Administrative Measures
    for the Information Disclosure of Commercial Franchise.

    16. How do the relevant government agencies enforce the disclosure
    requirements?

    Failure to disclose information in accordance with the law results in
    legal action by the Ministry of Commerce. If the error is minute, the
    department may order the franchisor to make corrections or impose
    a fine of between 10,000 and 50,000 renminbi (approximately
    US$1,460 to US$7,300).

    In more serious circumstances, a fine of between 50,000 and 100,000 renminbi
    (approximately US$7,300 toUSS$14,600) will be imposed and an announcement
    will delivered. Additionally, if a franchisor willfully fails to disclose or fraudulently
    misrepresents information, it will be subject to criminal liabilities.

    If a crime has not been committed but an entity acted in
    bad faith, the entity will be punished by the public security organ in
    accordance with the Law of the PRC on Public Security Administrative
    Punishments.

    17. What actions can franchisees take to obtain relief for violations
    of disclosure requirements? What are the legal remedies for such
    violations? How are damages calculated? If the franchisee can cancel
    or rescind the franchise contract, is the franchisee also entitled to
    reimbursement or damages?

    According to the general franchise regulations, the franchisee may
    unilaterally rescind the contract if a franchisor violates the minimum
    disclosure requirements. If the franchisor required a down-payment,
    the franchisee may also be entitled to a reimbursement of funds.
    Compensation will be granted only if the franchisee has strong
    evidential support that there was a breach of contract. In such a
    case, contract law sets precedent as to the compensation of damages.
    Generally, any monetary loss that is reasonable or foreseeable, or
    both, will be compensated.

    18. In the case of sub-franchising, how is liability for disclosure violations
    shared between franchisor and sub-franchisor? Are individual officers,
    directors and employees of the franchisor or the sub-franchisor exposed
    to liability? If so, what liability?

    A sub-franchisor assumes all the rights and responsibilities of the
    franchisor. As such, all regulations that apply to the franchisor apply
    equally to the sub-franchisor, including legal liabilities. Furthermore,
    it appears that since a franchise may only be established by a legal
    person, only a business entity may be legally liable, not a natural person
    (individual officers, directors and employees). However, the court
    ultimately decides in the preliminary hearing whether or not to enjoin
    a party. Hence, depending on the claim, an individual officer, director,
    or employee, or all, may be added as a party to the suit along with the
    business entity. In such a case, each party is equally liable.

    19. In addition to any laws or government agencies that specifically regulate
    offering and selling franchises, what are the general principles of law
    that affect the offer and sale of franchises? What other regulations or
    government agencies or industry codes of conduct may affect the offer
    and sale of franchises?

    The law is vague as to the specific principles and codes of conduct that
    must be followed when engaging in the offering and selling of franchises.
    In general, contract law, company law and the general principles
    of civil law set the legal precedents on engaging in transactions
    such as offering and selling a business entity. The State Council, the
    Ministry of Commerce and the SAIC, along with any local administrations,
    regulate these transactions. The application of other regulations,
    the involvement of other government agencies, or the institution of
    certain codes of conduct vary depending upon the industry.

    20. What other actions may franchisees take if a franchisor engages in
    fraudulent or deceptive practices in connection with the offer and sale of
    franchises? How does this protection differ from the protection provided
    under the franchise sales disclosure laws?

    China’s franchise regulations do not explicitly state the legal remedies
    available to a franchisee when a franchisor engages in fraudulent or
    deceptive practices in connection with the offer and sale of franchises.
    However, the franchisee will be entitled to consequential damages if it
    can provide evidential support for a breach of contract or a violation
    of the principles of fairness and reasonableness.
    Legal restrictions on the terms of franchise contracts and the
    relationship between parties involved in a franchise relationship

    21. Are there specific laws regulating the ongoing relationship between
    franchisor and franchisee after the franchise contract comes into effect?

    There are no specific laws regulating the ongoing relationship
    between franchisor and franchisee. The only applicable law would
    be the Contract Law of the PRC, which states that the franchisor
    and franchisee must deal at arm’s-length and obey the principles of
    fairness and reasonableness.

    22. Do other laws affect the franchise relationship?

    Other laws might apply depending on the industry. New stipulations
    might be adopted in the near future as the implementation of the law
    matures and the market begins to evolve. For the most up-to-date
    information on laws that affect the franchise relationship, visit the
    MOFCOM website.

    23. Do other government or trade association policies affect the franchise
    relationship?

    As previously stated, the franchise regulations of the PRC are in their
    initial stages of implementation. As such, the law is very vague as
    to whether other government or trade association policies affect the
    franchise relationship. In practice, other government or trade association
    policies might apply depending on the industry.

    24. In what circumstances may a franchisor terminate a franchise
    relationship? What are the specific legal restrictions on a franchisor’s
    ability to terminate a franchise relationship?

    The franchisor has an obligation to keep the contractual relationship
    with the franchisee for three years. After three years, the franchisor
    may terminate the contract without any legal restrictions. The contractual
    relationship may terminate before the end of the three-year
    span only if there is strong evidential support that there is a breach
    of contract or a violation of good faith.

    25. In what circumstances may a franchisee terminate a franchise
    relationship?

    A franchisee may unilaterally terminate the contract if the franchisor
    fails to disclose information. Other circumstances are not outlined in
    the franchise law, but, according to the Contract Law of the PRC, a
    franchisee may terminate the franchise relationship if there is a justified
    breach of contract.

    26. May a franchisor refuse to renew the franchise agreement with a
    franchisee? If yes, in what circumstances may a franchisor refuse to
    renew?

    After the requisite three-year period, a franchisor may refuse to renew
    the franchise agreement with a franchisee. The law is silent as to
    what circumstances permit renewal; nevertheless, according to the
    Contract Law of the PRC, the franchisor must still be fair and reasonable
    when deciding to terminate the franchise relationship (that
    is, act in good faith).

    27. May a franchisor restrict a franchisee’s ability to transfer its franchise or
    restrict transfers of ownership interests in a franchisee entity?

    Yes. The franchisee must seek permission from the franchisor before
    there can be a transfer of ownership. The franchising regulations do
    not restrict the franchisor from preventing a transfer of ownership
    from occurring; however, according to the Contract and Company
    Laws of the PRC, the franchisor must act reasonable when denying
    a transfer of ownership.

    28. Are there laws or regulations affecting the nature, amount or payment of
    fees?

    The current franchise regulations are silent as to the nature, amount
    or payment of fees. As such, the parties are free to negotiate the payment
    of fees. The Contract and Company Laws of the PRC prevent
    any corrupt transactions that violate the practices of good faith and
    the goodwill of the country. Criminal prosecution could result if the
    parties are found to have engaged in corrupt practices, especially for
    unjust enrichment.

    29. Are there restrictions on the amount of interest that can be charged on
    overdue payments?

    The current franchise regulations do not contain any restrictions on
    the amount of interest that can be charged on overdue payments.
    Other relevant laws are also silent as to the amount of interest that
    may be charged for overdue payments. In practice, the general rule is
    that the franchisor may charge interest as long as the interest charged
    is reasonable and not punitive.

    30. Are there laws or regulations restricting a franchisee’s ability to make
    payments to a foreign franchisor in the franchisor’s domestic currency?

    If a foreign franchisor establishes a FIE in China, the business
    entity is required to file the foreign exchange account with the State

    Administration of Foreign Exchange (SAFE). The government does
    not guarantee that the renminbi generated by the franchisee will
    be converted into foreign currency. Comparatively, if the franchisor
    maintained its domicile abroad while engaging in a contractual relationship
    with a franchisee, then it may possess an offshore account
    where minimal legal restrictions apply. In such a case, the money
    generated may be freely transferred to the franchisor’s domestic currency
    as long as neither party engages in an illicit activity.

    31. Are confidentiality covenants in franchise agreements enforceable?

    Yes. The general regulations contain a specific provision that makes
    confidentiality covenants binding.

    32. Is there a general legal obligation on parties to deal with each other in
    good faith? If so, how does it affect franchise relationships?

    Yes. Article 4 of the Commercial Franchise Regulation specifically
    states that, ‘the principles of free will, fairness, honesty, and good
    faith shall be followed. In addition, the Company and Contract law
    of the PRC both state that parties must deal in good faith’.
    Acting in good faith implies that both parties must act at arm’s length
    from each other. As such, unconscionability, fraud, misrepresentation,
    deceit and other practices of bad faith warrant rescission
    by the promise and the payment of damages from the promisor.

    33. Must disclosure documents and franchise agreements be in the language
    of your country?

    The franchise regulations do not stipulate whether the disclosure
    documents and franchise agreements given to the franchisee must
    be in Chinese; however, all information submitted to the local agencies
    and MOFCOM or the SAIC must be in Chinese. Furthermore,
    the Chinese government requires that all claims and documents be
    translated in Chinese prior to submitting a claim to court or the arbitration
    committee.

    34. What restrictions are there on provisions in franchise contracts?

    The regulations do not provide specific provisions that restrict
    the terms of a franchise contract; nevertheless, there are several
    laws that provide certain restrictions on doing business in China.
    Recently, the State Council released a general declaration emphasizing
    that businesses may not limit the transfer of high-tech knowhow,
    engage in willful deceit (especially in regards to the validity
    of patent rights) or create contractual burdens. Most importantly,

    China has recently adopted an anti-monopoly law which will add
    certain restrictions as to establishing franchises in China. Generally
    speaking, the government restricts any practice that would
    be against the national interest including, inter alia, illicit trade,
    exploitation of others and willful misrepresentation. Specific restrictions
    depend on the location and type of industry the franchise is
    engaged in.

    It is important to note that the new regulations seem to impact
    foreign franchisors more than domestic franchisors. Domestically,
    these regulations are merely a different type of contractual relationship.
    For the foreign entity, not only must it comply with all the
    applicable regulations according to its industry, but it must also obey
    the current stipulations. Overall, the current regulations have added
    another layer of restrictions for the foreign franchisor. In addition,
    foreigners often run into cultural barriers, especially when establishing
    a franchise. In order to limit these systemic barriers, it is strongly
    As the franchise regulations mature, more clarification will be given
    on how to establish and maintain a franchise in China. In fact, the
    State Council is continuously producing declarations or supplemental
    regulations that provide more guidance on the implementation of the
    initial law. As such, it is essential that each interested investor keeps up
    to date with information on the law.

    Current and future franchisors should pay attention to the effects
    of the newly enacted anti-monopoly law. Many foreign investors fear
    that this law will be used as a tool to further restrict foreign industry. Of
    course, due to the recent enactment of the law, these concerns remain
    unfounded in practice. Nevertheless, this new law provides hope for
    foreign investors that the Chinese are becoming more liberal with their
    regulations on establishing a business in China

    Another trend that investors must keep an eye on is the constant
    revision of intellectual property (IP) rights, especially if the franchise
    necessitates patent protection. The State Council is constantly refining
    the law in order to ensure adequate protection, but has yet to acquire a
    strong enforcement mechanism that prevents numerous IP infringements.

    Recently, there have been several proposals, symposiums and declarations
    from the government addressing issues regarding the lack of protection.

    Finally, investors, both foreign and domestic, should acquire legal
    counsel to help navigate the evolving laws of the PRC.

    32. It is advisable that each foreigner engages in ongoing consultation with
    a Chinese partner.

    33. Describe the aspects of competition law in your country that are relevant
    to the typical franchisor. How are they enforced?

    In order to best protect the evolving needs of the current market
    economy, China has adopted its first anti-monopoly law, effective
    as of 1 August 2008. This law provides guidelines towards limiting
    the monopolization of the market by both foreign and domestic
    enterprises. The law itself is intentionally vague so as to allow industry
    specific regulations to take precedent. Overall, the law prohibits
    certain types of agreements unless they fall within an exemption,
    prohibits behaviors classified as abuse of dominant market position,
    provides a framework for determining when dominance exists,
    establishes a broad merger review scheme and, most importantly,
    prohibits abuse of government administrative powers restraining
    competition.

    34. Very briefly describe the court system. What types of dispute resolution
    procedures are available relevant to franchising?

    The highest court is the Supreme People’s Court, which supervises
    all subordinate local and special people’s courts. The Local People’s
    Court includes, in ascending order, the Grass-roots People’s Court,
    the Intermediate People’s Court and the Higher People’s Court. Generally,
    the Grass-roots People’s Courts are located at the municipal
    district and autonomous county level.
    The Intermediate People’s are established in capitals or prefectures at the provincial
    level. The Higher People’s Courts, located in all provinces, autonomous
    regions, and municipalities, are directly under the control of
    the Central Government. China practices a system of courts characterized
    by ‘two instances of trial’ where the judgments and orders of
    the appeal shall be seen as final decision of the case. It is important to
    note that most cases are rarely litigated and are rather settled through
    administrative agencies or party negotiations. Preferable for franchising
    claims is arbitration, which is considered another practical and
    quick approach for dispute resolution.

    Article by:
    China
    Tian Fengchang
    Longan Law Firm

China's New Franchise Regulation: Three Steps in the Right Direction

China's New Franchise Regulation: Three Steps in the Right Direction

by Philip F. Zeidman and Tao Xu

Almost exactly two years ago, on February 1, 2005, the Measures for the Regulation of Commercial Franchises (Measures) issued by the People's Republic of China's Ministry of Commerce (MOFCOM) went into effect.

Since their inception, the Measures have been the subject of non-stop discussion in the international franchising community—not only because the Chinese market is so important, but because of the (in)famous "two plus one" requirement. That requirement was thought by some to be a precursor of coming change in the franchise laws in other countries. Indeed, that has proved to be the case in Vietnam.

But, from the outset, the Measures operated under a cloud: the looming Regulation on Commercial Franchises (Regulation), which has been in the works for several years. Because this Regulation would be issued by the State Council, it would have much more weight, and more teeth, than the Measures. Many also hoped that the Chinese government would use the Regulation to reconsider the issues important to healthy development of franchising in China, as well as to adjust its approach to regulating franchising.[†]

Under the more opaque system of legislative drafting in China, it is impossible to determine who made what approaches or arguments to the government. The International Franchise Association advocated extensively before the Ministry of Commerce, the Legislative Affairs Office of the State Council, and other agencies.

The new Regulation (approved "in principle" by the State Council on January 31, signed by the prime minister on February 6 and promulgated to be effective on May 1), represents a major improvement over the Measures, reflects the Chinese government's willingness to adopt a more liberal regulatory regime, and confirms that these efforts of IFA have been well spent.

To be sure, there are many uncertainties that remain to be resolved. For some foreign franchisors, the revised regulatory regime still represents a significant hurdle, although it is by no means insurmountable, as we have seen in our representation of clients in China. For the moment, we would like to report to our clients and friends on three important steps that the Regulation has taken in the right direction.

1. A Relaxation of the "Two Plus One" Requirement

The Measures require that a franchisor (or its subsidiary) must have two direct-operated outlets which have been in operation for more than one year, before it can franchise in China. Article 7 of the Regulation now provides:

(1) A franchisor, when engaging in franchise operation, shall own a well-developed mode of operation and be capable of continuously providing operational guidance, technical support, business training, and other services to the franchisee.

(2) A franchisor shall own at least two directly-operated outlets, and have operated for more than one year.

Careful readers will see that there is no explicit requirement that the outlets be "within China," a silence that is clearly of potential benefit to foreign franchisors. The intent of this change is to give MOFCOM latitude in deciding what exactly this requirement will entail and how it will be administered. Although we cannot be certain, we believe that MOFCOM will not require, for foreign franchisors, that their two company units be within mainland China. That result would, of course, represent the success of the long advocacy efforts.

We should note, however, that this is merely a step in the right direction; it is not, by any means, a fully developed regulatory requirement that is unambiguous in its application. On the contrary, questions abound:

Can we be certain that MOFOCM will not administratively introduce the "in China" requirement?How will the company-owned operations of the franchisor's affiliates be treated?How will the term "direct-operated outlets" be interpreted? Will that include businesses not owned but managed by the franchisor (or its affiliate)?The wording of the revised "two plus one" rule seems to suggest that the two company-owned stores themselves need not be open for more than one year, so long as the franchisor's company-owned operation as a whole has achieved that duration. Is that intended?What documents will the Chinese government require in verifying franchisors' (especially foreign franchisors') satisfaction of this requirement?

Few franchisors will want to proceed without assurance regarding these issues. MOFCOM has indicated that it will prepare "implementation guidelines" to address many of the uncertainties in applying the Regulation. We will monitor and provide updates on the drafting of these "implementation guidelines."

2. A Turn from "Approval" to "Registration"

Instead of requiring each franchisor to be "approved" and obtain a "franchise license" before starting to franchise in China (an approach that appeared in the drafts dated as late as May 2006), the Regulation's Article 8 now provides that franchisors need only "register" with the provincial government or MOFCOM (for those who will engage in "cross-province" franchising).

Such registration is required within 15 days after the franchisor sells its first franchise. Franchisors who have already been franchising in China are required to register by May 1, 2008.

The government agency is required to register a franchisor within 10 days following its receipt of all the required documents, which includes copies of certificate of incorporation or business license, form franchise agreement, operations manual, market plan, and evidence of franchisor's satisfaction of Article 7 (see above). Notably, franchisor's disclosure document and audited financial statements are not required (although they are still required to be provided to prospective franchisees).

For US franchisors who are already accustomed to meeting registration requirements in certain US states, the use of the term here under the Regulation may be misleading. "Notice filing" is probably closer to what the Regulation actually contemplates.

3. A Recognition of the Independent Relationship between "Franchisor" and "Designated Supplier"

For quite some time now, we have expected that the Regulation would include the changes we cite above under #1 and #2. Another change, however, was not anticipated, but it is quite heartening.

In the past and, indeed, despite strong arguments by IFA, throughout much of the process of drafting the Regulation, Chinese officials took a firm stance that a franchisor would be jointly and severally liable for the products and services provided by its designated suppliers. This feature appeared in the Measures, and persisted throughout various drafts of the Regulation. Happily, the Regulation is a complete contrast to this. In the new Regulation, a franchisor is not jointly and severally liable for the products and services provided by its designated suppliers.

Disclosure Requirements under the Regulation

The disclosure obligations under the Regulation remain roughly the same as under the Measures in terms of the substance, with a few adjustments. For instance, the government reserves the authority to request additional disclosure obligations—a troubling, although typical, approach. The Regulation also imposes some new obligations (e.g., a mandatory "cooling-off" period (although without a specified period of time), and much harsher penalties on violations.

A Vital Step toward an Efficient Regulatory Regime

As we indicated, the Regulation is by no means a perfect document, and much remains to be clarified by Chinese officials, through MOFCOM's implementation guidelines and otherwise. The devil, as always, will be in the details.

Nonetheless, we are quite encouraged by these steps that the Chinese government has taken in the direction of an effective and efficient regulatory regime, which will greatly benefit both franchisors and franchisees in China. With the Chinese New Year upon us, here's hoping that the Year of Golden Boar will bring more good news from China.

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